WASHINGTON - Changing market conditions are spurring municipal issuers to turn to Treasury and other marketable securities' instead of the standard Slugs the government sells to help state and local authorities carry out advance refundings.

Municipal bond analysts, issuers, and Treasury officials agreed in interviews this week that issuers who choose securities other than Slugs can get a few basis points more in yield that will shave costs in many refundings.

"The steepness of the yield curve appears to be making it possible for entities to pick up yield by buying marketable securities," said one Treasury official familiar with the Slugs program.

Slugs, or state and local government series securities, are a special series sold by the Treasury to municipalities to permit compliance with arbitrage restrictions get by the Internal Revenue Code. Each day, the Treasury sets yields on the different Slug maturities at 1/8 of a percentage point, or about 12.5 basis points, below comparable market yields. Maturities are tailored to meet the requirements of the issuers.

The key change in the yield curve is the wide spread between shortterm rates, which have tumbled this year on continued easing by the Federal Reserve, and intermediate and long-term rates, which have come down less dramatically.

As a result, issuers doing advance refundings are finding that the yield of the securities they buy to put in escrow accounts to defease, or pay off, their bonds over time are well below the yields of the refunding bonds. In the jargon of the bond industry, issuers find themselves in a "negative arbitrage" situation where they could lose money. They invest in Treasuries rather than Slugs to get as close as possible to the yield of the refunding bonds to minimize those losses.

For example, an issuer today might wish to defease a bond yielding 8% that is callable in three years with a 15-year municipal bond at 6.4%. An issuer buying three-year Slugs from the proceeds gets only 4.19%, which is less than the yield on the municipal bond and less than the 4.31% that can be earned on a three-year Treasury note.

The situation is forcing municipal issuers to take a hard look at changing rates in the municipal and open markets in an effort to find the best time to do a refunding.

"The shape of the yield curve is creating an enormous negative arbitrage problem for a lot of refundings," said George Friedlander, managing director of Smith Barney, Harris Upham & Co. "When you put together a deal you have to be very nimble."

The Massachusetts Water Authority is set to come to market next week with a $400 million refunding of revenue bonds yielding between 7.30% and 7.70%, but the deal may be delayed because of shifting market conditions and the costs of negative arbitrage, said Phil Shapiro, chief financial officer for the authority.

We're talking millions of dollars worth of arbitrage, and things are very sensitive to changes in municipal rates, and they're also very sensitive to changes in the Treasury, rates." said Mr. Shapiro.

He predicted a refunding could bring an estimated $11 million to $12 million in savings. But as much as a third of that, some $3 million to $4 million, could get eaten up in arbitrage costs even with the purchase of marketable Treasury securities instead of Slugs.

Right now, the refunding market is booming. In August, 28 of the 50 largest bond issues were for refunding or combined refunding and new-money deals.

The two largest issues were a $1.17 billion New York City refunding of general obligation bonds and a $1.04 billion refunding of New York City Municipal Water Finance Authority water and sewer bonds. In both cases, city finance officials chose to buy a range of Treasury bills, notes, and bonds rather than Slugs for the escrow accounts. The city also bought some Refcorp and Treasury Strips.

Roger Anderson, New York's bureau chief for debt management, said his office had to run a sophisticated computer program to figure out the types and maturities of marketable debt that could be bought to capture higher yield and continue to comply with the arbitrage rules. Analysts had to compare the potential earnings with what they could get from Slugs, which have the appeal of their specially tailored maturities.

In the end, said Mr. Anderson, "the better yields in the open market securities outweighed their inefficiencies. We saved a lot of money and certainly having the option of buying open-market Treasuries helped us save more. "

Municipalities are far from abandoning Slugs, which issuers typically find convenient for compliance with the arbitrage rules. Gross Slug issuance through August totaled $18.9 billion, 57% higher than the $12 billion recorded over the same period last year, according to an analysis by R.H. Wrightson & Associates. A Treasury official confirmed the figures.

But refunding volume is up even more dramatically this year. The Public Securities Association says gross municipal refundings doubled to $41.9 billion in the first half from $20.4 billion in the same period last year.

Analysts said there are other ways besides purchases of marketable securities to minimize negative arbitrage in refundings.

Last September, the Port Authority of New York and New Jersey refinanced an $86 million bond bearing an 11% coupon with a forward contract. The deal carried a true interest cost of 7.4% and an estimated savings of $86 million.

But analysts also say that small issuers as well as large ones that refund debt can find savings by staying out of the Slugs market. J.B. Kurish, director of government finance research for the Government Finance Officers Association, estimated marketables could be used for refundings as small as $20 million to $30 million.

"There are some very well-managed local municipalities out there that have very top-notch people or financial advisers," he said. "I think there's probably a lot of room for this. You don't have to have a big deal to save money."

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